China's unprecedented clampdown on its education sector has sparked debate about which industry will be next to be caught in Beijing's crosshairs, and has also called into question the use of a legal structure that underpins trillions of dollars worth of foreign investment in Chinese companies.
On July 24, China's State Council, effectively its cabinet, and the Central Committee of the Chinese Communist Party, a top political body, issued new rules that will force K-12 after-school tutoring companies to register as non-profits and ban foreign investment in these companies either via M&A or variable interest entity arrangements.
The VIE structure makes use of offshore special purpose vehicles to circumvent China's rules on foreign ownership and is used by a number of US-listed Chinese companies, including giants like Alibaba Group Holding and Tencent Holdings.
While regulatory risk has long been a concern for foreign investors in China – highlighted when Ant Group had to pull its US$37bn IPO last year as oversight of technology firms intensified – the sweeping measures effectively gutted the country's US$100bn private education industry overnight.
Goldman Sachs analysts estimated that it would lead to a 70%–90% drop in revenues for K-12 after-school tutoring companies, and the share prices of the three largest companies in the industry – TAL Education, New Oriental Education and Gaotu Techedu – each plummeted by more than two-thirds after news of the plans leaked in the media on July 23.
Affected too was food delivery giant Meituan, whose share price fell 14% on Monday and a further 18% on Tuesday, its worst two-day performance to date, after the State Administration for Market Regulation on Monday issued new guidance for online food platforms including a requirement that workers earn at least the minimum wage.
News of the reforms immediately concentrated minds on what next steps the CCP would take as it seeks to wrestle control over the economy and rein in industries it considers responsible for a cost of living crisis that has led to the country's low birth rate, a looming demographic crisis that concerns the CCP. China has presented its recent regulations as measures to reduce inequality and ease the burden on families.
"The goalposts keep moving every day so it is impossible to predict with much certainty what will be next, although one common theme has been that the Chinese government wants to lower the cost of living to avert the demographic time bomb it faces so certain sectors such as real estate could face further regulatory scrutiny," said one Singapore-based research analyst focused on China.
Spillover sectors
China has spent years trying to grapple with rising property prices and has made little headway, although one US-based analyst who covers China said that he expects this to change given that the country's top banking regulator Guo Shuqing has spoken about the risk of the property bubble being a "grey rhino", a term coined by former IFR journalist Michele Wucker that refers to a risk that is obvious but is not addressed.
On July 23, the Shanghai branch of the People's Bank of China ordered banks to raise mortgage loan rates, while the same day eight regulators including the National Development and Reform Commission also said they would impose tougher penalties on property developer misconduct.
Similarly, healthcare is another sector that analysts see as vulnerable after the State Council said last month it will focus on reducing drug prices.
The Hang Seng Healthcare Index fell 9% on Monday and 9% again on Tuesday with stocks that overlap with tech such as JD Health International and Alibaba Health Information Technology faring particularly poorly. The Hang Seng Property Service and Management Index fell 9% on Monday and 8% on Tuesday. This compared with a 4% drop in the main Hang Seng Index on Monday and a further 4% dip on Tuesday.
VIEing for attention
China's clampdown on the education sector has also thrust the spotlight back on VIEs given that it has banned their usage in the industry, prompting market observers to ask whether this would apply to other sectors.
VIEs operate in a legal grey area and while by no means unique to China (they were originally made popular in the US by Enron), they are typically used by Chinese companies listing in the US.
This is because of restrictions Beijing places on foreign ownership in certain sectors. To get around the restrictions, the issuer sets up a shell company, usually in the Cayman Islands, which has a controlling interest based on a series of contractual arrangements rather than because it has a majority of voting rights.
The SPV is listed on an overseas exchange with foreign investors owning a stake in it rather than the onshore Chinese operating entity. These types of structures are not officially recognised by China, although it has historically tolerated them at least. Some market observers said this could change though as tensions between the US and China point to further financial decoupling.
A new rule from the US Securities and Exchange Commission could also make it hard for Chinese companies to remain listed in the US.
In March, the SEC said it would begin adopting the Holding Foreign Companies Accountable Act, which would boot companies off US exchanges if they fail to comply with US oversight of their audits for three consecutive years.
This is something China tends to refuse on security grounds and last month it passed a new law that prohibits companies from handing over data to foreign governments without approval by the Chinese government.
"These types of structures work until they don't work. Any disputes that have arisen have tended to be quite technical around things like foreign investors having difficulties repatriating money from the operating entity to the offshore company, but that doesn't mean that China won't take a more prescriptive approach in the future," said one Beijing-based lawyer.